Summary

Value investing gurus can fail you. Defensive stocks can fail you. All Stocks can fail you: 40% of them have suffered catastrophic losses since 1980.

Your mind deceives you. Science shows you have a tendency to be bullish about assets you own (even about ones you pretend to own) despite facts to the contrary.

These are all rational reasons to panic if you aren't strictly limiting your risk. We elaborate and offer an approach to strictly limit your risk while maximizing your expected return.

Reasons To Panic

After a market plunge, sure as night follows day, come the flurry of articles telling you not to panic. Those articles usually offer versions of one or more of the following bromides:

"Stocks are on sale: time to add to your positions in defensive stocks and 'dividend champions' to boost your retirement income."

"Be greedy when others are fearful! Follow the wisdom of great value investors."

"Focus on the long term."

"Time to buy more of XYZ, it's a 'hold forever' stock."

Allow me to disagree.

If you haven't taken steps beyond those bromides to strictly limit your risk, there are good reasons to panic. Here are some of them.

The Value Investing Gurus You Follow Can Fail Spectacularly

Storied value investor David Einhorn (pictured below above; image via Dealbreaker) invested in SunEdison (SUNE). Three months after it failed one of two screens to avoid bad investments, it was down 71%; in the month since, it's dropped another 30%. See the chart below via the Yahoo mobile finance app for how SUNE has done over the last 12 months.

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Another storied value investor, Mohnish Pabrai (pictured above, in his office nap spot, in a photo by Ian White for Forbes), who once had lunch with Warren Buffett, invested in Horsehead Holding (ZINC), presumably after subjecting it to his rigorous, 98-question checklist. See the chart below, via the same Yahoo app, for ZINC's performance over the past year. Like SUNE, it's down about 90%.

Click to enlarge

Defensive Stocks Can Fail You Too

Seeking Alpha contributor Sy Harding pointed this out in a classic article of his ("Don't Fall For The 'Defensive Portfolio' Hype"):

The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But the advice remains the same in every cycle.

After the market seemed to top out in the year 2000, the stocks most recommended as defensive stocks included Alcoa (NYSE:AA), Bristol Myer Squibb, Citigroup (NYSE:C), Coca-Cola, Disney (NYSE:DIS), DuPont (NYSE:DD), Fannie Mae, General Electric (NYSE:GE), Home Depot (NYSE:HD), IBM (NYSE:IBM), Merck (MRK), and Wal-Mart (NYSE:WMT). However, they plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the Dow's decline of 38% and the S&P 500 decline of 49%.

Let's pause for a moment to assure any younger readers that yes, Citigroup (NYSE:C) was once considered a blue chip, defensive stock.

All Stocks Can Fail You

In a previous article ("Hedge After Reading"), we noted a striking statistic JP Morgan (NYSE:JPM) researchers uncovered in their study of Russell 3000 companies from 1980 to 2014: during that time period, 40% of stocks suffered catastrophic declines of 70% or more without recovering.

You Are Misled By Wishful Thinking

Among those reading this article now are likely holders of ZINC and SUNE who rode those stocks down ~90% slides over the last year. Undoubtedly, they did so, because they expected the stocks to recover, and that expectation is natural. In his Financial Times column in November ("When Wishful Thinking Becomes Wasteful"), Tim Harford cited research by behavioral economists showing that we are inclined toward wishful thinking that can cloud our expectations about asset prices:

Guy Mayraz, a behavioral economist at the University of Melbourne, conducted a test of wishful thinking a few years ago. He divided experimental subjects into "farmers", who benefited from high wheat prices, and "bakers", who profited when wheat was cheap. He showed them historical charts of wheat prices and asked them to make forecasts, paying a bonus for accuracy. The farmers systematically predicted higher prices than the bakers. This is wishful thinking in its purest form.

You Have No Idea What The Future Holds

Thinking of taking advantage of a down market to buy more shares of a "hold forever" stock? Think again. Forever is a long time, and even among the best forecasters, predictions beyond five years are "basically a stab in the dark". That quote comes from a man who would know, psychologist Philip Tetlock, whose book Superforecasting was reviewed in the Financial Times over the weekend ("The Vision Thing"). Stephen Cave summarizes the background in his review:

Superforecasting is based on Tetlock's most recent study, the Good Judgement Project, in which he and colleagues recruited more than 20,000 people to make 500 predictions on questions ranging from the likelihood of political protests in Russia to the course of the Nikkei index. Tetlock's team was one of five competing in a competition sponsored by IARPA, the research and innovation arm of the US intelligence community, which also set the questions. But Tetlock's recruits were so much more successful that IARPA dropped the other teams two years into the four-year contest.

Those 20,000 people Tetlock recruited were all good forecasters, but only the most accurate among them were designated Superforecasters, and their predictions were given extra weighting. These Superforecasters were more accurate than intelligence community professionals, and even they have no idea what will happen more than five years out. And you know that your "hold forever" stock will be okay more than five years from now? You really don't know that.

Avoiding Panic By Strictly Limiting Your Risk

Just because we can't find a safe harbor in unhedged stocks doesn't mean we need to tolerate unlimited risk. We can strictly limit our risk by holding sufficient cash or by making sure each of our investments is hedged.

The simplest way to strictly limit your risk is to limit the amount of your portfolio that's not in cash. So, for example, if you were unwilling to risk a drawdown of more than 12%, you could keep 88% of your portfolio in cash. Even if the rest of it went to zero, you would only be down 12%. The advantage of this, in addition to its simplicity, is that it doesn't cost anything up front. Of course, the disadvantage to using cash to limit risk in this manner is that it's a huge drag on returns in the absence of a disaster.

Another approach would be to hedge each position in your portfolio against a >12% drop. The disadvantage of this is that hedging has a cost, so it's important to try to minimize that cost. The advantage of this approach is it lets you concentrate your assets in securities that have higher potential returns than cash.

Limiting Hedging Cost Versus Maximizing Potential Return

If you calculate the hedging cost of very optionable security in the US, and sort for the ones that are cheapest to hedge, the names that come up as the absolute cheapest to hedge generally have low potential returns. For example, the name topping Portfolio Armor's cheapest-to-hedge list as of Wednesday's close was Dyax Corp (NASDAQ:DYAX). The site calculated a 0% potential return for it for the same reason DYAX is so cheap to hedge: It is trading within pennies of the price Shire Plc (NASDAQ:SHPG) agreed to acquire it for.

On the other hand, if you estimate potential returns for every optionable security, the ones with the highest potential returns may also have high hedging costs. So what we do instead is to calculate potential returns for securities and then subtract the costs of hedging them to get potential returns net of hedging costs, or "net potential returns". The essence of our hedged portfolio method is to buy a handful of securities with the highest net potential returns, and hedge them in accordance with your risk tolerance.

A Sample Portfolio Hedged Against A >12% Drawdown

If you had $50,000 to invest, and, like our hypothetical investor mentioned above, were unwilling to risk a drawdown of more than 12% over the next six months, this is the hedged portfolio our site would have presented you as of Wednesday's close, to maximize your expected return while strictly limiting your downside risk to no more than 12%:

Why These Particular Securities?

As of Wednesday's close, Activision Blizzard (NASDAQ:ATVI), NVIDIA (NASDAQ:NVDA), and Raytheon (NYSE:RTN) were all among the highest-ranking names in the site's universe when sorted by net potential return. The site rounded down dollar amounts to get round lots of each of them, and then, in the fine-tuning step of its portfolio construction process, allocated the leftover cash from the rounding down to the Direxion Daily 3x Small Cap Bear ETF (NYSEARCA:TZA), which it added as what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications (in this case, to a drawdown of no more than 12%).

Note that neither Amazon (NASDAQ:AMZN) nor Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) appear in this portfolio, despite both of them ranking among our top names by net potential return. The reason is that their share prices are too high to buy round lots of them in a $50,000 portfolio, so Portfolio Armor automatically excluded them from consideration.

Let's turn our attention now to the portfolio-level summary, starting with the most important part for risk management purposes.

Worst-Case Scenario

The "Max Drawdown" column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 11.22%. That 11.22% maximum drawdown is inclusive of the 1.98% hedging cost shown in the portfolio level summary, i.e., the portfolio value would only be down 9.24% not including the hedging cost, in a worst case scenario.

Best-Case Scenario

At the portfolio level, the net potential return is 15.42%. This represents the best-case scenario if each underlying security in the portfolio meets or exceeds its potential return.

A More Likely Scenario

The portfolio level expected return of 6.23% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns.

Each Security Is Hedged

Note that in the portfolio above, each underlying security is hedged. In this case, they're each hedged with collars, but the site will hedge with puts instead if it can get a higher net potential return by doing so. Below is a closer look at the optimal collar hedge for RTN.

As you can see in the section of the screen capture above (image via the Portfolio Armor iOS app), this collar is capped at 21.97%. That's because that's the potential return the site calculated for the stock over the next several months. The cost of the put leg of the collar was $655, or 5.4% of position value. However, if you look at the section of the screen capture below, you'll see that the cost of the put leg was partially offset by income of $73, or 0.6% of position value, from the short call leg.

So the net cost of this collar was $582, or 4.80% as a percentage of position value. Note that, to be conservative, the cost here was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less (at some price between the bid and ask), and sell calls for more (again, at some price between the bid and the ask), so the actual cost of this hedge would likely have been less. The same is true of the other hedges in this portfolio, as they were calculated in a similarly conservative manner.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.